Divergence in Trading: Origin, Types, and Strategies for Use

Top Indicators for Spotting Divergence Signals

Before understanding divergence, traders should familiarize themselves with the tools used to track these signals. Generally, common formulas come from Oscillators or momentum measurement tools.

RSI (Relative Strength Index) is a measure indicating overbought (Overbought) conditions when RSI is above 70 and oversold (Oversold) when RSI is below 30. This tool is useful for observing changes in price momentum.

MACD relies on two moving averages to identify trading signals. When MACD values increase and turn positive, it indicates strong buying pressure. Conversely, a decreasing negative MACD suggests intensified selling pressure.

Williams %R measures overbought and oversold conditions. Values above 80 indicate Overbought, while below 20 indicate Oversold. Signals appearing in these zones often suggest significant trend reversals.

What is Divergence: Definition and Importance

Divergence occurs when price and technical indicators move out of sync with differing strengths. This does not mean the indicator fails but signals that the current trend may be losing momentum.

When prices continue to decline but indicators do not confirm the strength of the trend, or vice versa, traders need to stay alert, as this could signal a trend reversal or continuation depending on the type of divergence.

Types and Significance of Four Divergence Patterns

1. Price Down but Still Strong: Bullish Divergence

When the price makes a new low but the indicator does not confirm this decline, it may indicate weakening downward momentum and a potential upward move approaching.

2. Price Up but Still Strong: Bearish Divergence

When the price makes a new high but the indicator does not show increased strength, it warns that the upward momentum is waning.

3. Weakening Downtrend but Indicator is Strong: (Hidden Bearish Divergence)

This situation suggests the downtrend may continue, with prices only slightly adjusting.

4. Weakening Uptrend but Indicator is Strong: (Hidden Bullish Divergence)

The uptrend still has momentum; prices just recently broke below the moving average.

Regular Divergence: Strong Reversal Signal

Regular Divergence occurs when the price moves fully in one direction but the indicator fails to follow, often leading to a significant trend reversal.

Real-world example of Bullish Divergence:

The coin’s price continues downward and hits a new low (Lower Low), but RSI does not break the previous low, failing to confirm the strong downward force. This indicates weakening selling pressure and a potential upward move. When the candlesticks turn green, it’s time to consider buying.

Real-world example of Bearish Divergence:

The price creates a new high (Higher High) repeatedly and continues upward, but RSI or MACD do not support this move, showing no new highs. This warns that the upward momentum may be fading, and a sharp decline could be imminent. When a red Shooting Star candlestick appears, consider selling.

How to utilize Regular Divergence:

• Watch for Higher High / Lower Low in price
• Compare with RSI, MACD, or Williams %R movements
• Wait for confirmation patterns like Double Top or Double Bottom
• Set a stop loss at a certain level for verification
• Enter positions once confident

Hidden Divergence: Continuation Signal

Hidden Divergence is the opposite, indicating that the existing trend remains alive and continues. Prices may adjust slightly, but indicators still show strong momentum.

Example of Hidden Bullish Divergence:

Prices are climbing, but during a minor pullback (Pullback), they form only a Higher Low, not reaching the previous low. RSI shows that during the pullback, RSI also declines but does not drop below the previous low, remaining above 50, suggesting ongoing strength and a likely continuation of the recovery.

Example of Hidden Bearish Divergence:

Prices continue downward, with minor rebounds (Bounce) creating only a Lower High. RSI or MACD do not show new highs, remaining relatively low, indicating strong downward force and likely further decline.

How to utilize Hidden Divergence:

• Look for Higher Low (in an uptrend) or Lower High (in a downtrend)
• Observe if indicators remain strong
• When signals appear, follow the existing trend
• Wait for price to test the current range before entering new positions
• Use loose Stop Losses, as this indicates trend continuation

Avoid Common Mistakes When Trading Divergence

Divergence is a useful signal but not 100% accurate. False signals can occur multiple times before a true trend change. Traders should keep these facts in mind:

• Wait for confirmation: Do not enter a position based solely on divergence signals. Wait for clear price movements.
• Use Stop Loss: Proper stop-loss placement is crucial to protect capital if the signal proves false.
• Study longer timeframes: Divergence on hourly or daily charts is more reliable than on shorter frames.
• Combine with other tools: Do not rely solely on divergence; incorporate other signals like support/resistance levels or additional indicators.

Summary

Bullish Divergence and Bearish Divergence are essential tools for predicting price reversals, while Hidden Divergence helps confirm trend continuation. Recognizing both types and applying them with risk management can strengthen your trading strategies.

Remember, divergence is only a signal, not a law of nature. Your practice and mental discipline are more important than any tool.